UK Corporate Governance Code
For premium listed companies and other companies that have chosen to “comply or explain” against the UK Corporate Governance Code (Code), a revised version of the Code applies to accounting periods beginning on or after June 17, 2016. The Financial Reporting Council (FRC) consulted on changes to the Code back in 2014 and 2015, largely as a result of changes required to it by the EU Regulation regarding the statutory audit of public interest entities (EU Statutory Audit Regulation - Regulation EU/537/2014) and the EU Directive on the statutory audit of annual accounts and consolidated accounts (EU Statutory Audit Amending Directive - Directive 2014/56/EU). The EU Statutory Audit Regulation and the EU Statutory Audit Amending Directive both apply with effect from June 17, 2016.
The main changes between the new version of the Code and that published in 2014 for accounting periods beginning on or after October 1, 2014, are as follows:
- New wording has been added to Code Provision C.3.1 to require the audit committee, as a whole, to have competence relevant to the sector in which the company operates.
- The reference in Code Provision C.3.7 to FTSE 350 companies putting the external audit contract out to tender at least every ten years has been deleted as this requirement is now included in the Companies Act 2006 following amending legislation to implement the EU Statutory Audit Directive and the EU Statutory Audit Regulation.
- Wording has been added to Code Provision C.3.8 which sets out what the audit committee’s report in the annual report should include, to specify that the audit committee should give advance notice of any audit retendering plans. The FRC wants this to result in the reporting of retendering plans only when they are focused and relevant.
It is worth noting that the FRC’s next review of the Code is planned for 2019 and it hopes to avoid further updates before then.
FRC’s Guidance on Audit Committees
At the same time as issuing the revised version of the Code, the FRC issued revised Auditing and Ethical Standards to support the work of auditors in delivering high quality audits, as well as an updated version of its Guidance on Audit Committees, last published in 2012 (Guidance).
The Guidance has been revised to take account of the changes to the Code and to the regulatory framework in light of the implementation in the UK of the EU Statutory Audit Regulation and the EU Statutory Audit Amending Directive, as well as developments such as the recommendations and Orders of the Competition and Markets Authority in relation to audit engagements.
The Guidance, which should be read in conjunction with Section C.3 (Accountability) of the Code, has been amended to reduce duplication with elements of the Code and changes include the following:
- The audit committee composition section has been rearranged to provide that a range of skills, experience, professional qualifications and knowledge are important in forming an audit committee and that the requirements for recent and relevant financial experience and sectorial competence flow from that broader requirement.
- The role of the audit committee in relation to the fair, balanced and understandable statement made by the board in relation to the annual report and accounts has been clarified.
- The section on communication with investors has been amended to reflect the expectation that interaction with investors encompasses more than just the reporting included in the annual report, and to provide flexibility in the placement of the audit committee’s report in the annual report.
As a result of needing to reflect changes introduced by the EU Statutory Audit Amending Directive, the Financial Conduct Authority (FCA) has made a number of changes to DTR 7.1 concerning audit committees and the changes (in FCA Instrument 2016/40) apply to issuers with a financial year beginning on or after June 17, 2016.
As before, at least one member of the audit committee must have competence in accounting or auditing, or both, but now a majority of its members must be independent and the members of the audit committee as a whole must have competence relevant to the sector in which the company is operating. In addition, the chairman of the audit committee must be independent and be appointed by audit committee members or by the board of the company.
Additions have been made to DTR 7.1.3R which sets out the minimum duties of the audit committees, to reflect the amended scope of responsibilities under the EU Statutory Audit Amending Directive. For example, as well as continuing to monitor the financial reporting process, the audit committee must now submit recommendations or proposals to ensure its integrity of the financial reporting process. While monitoring the audit, the audit committee must take into account any findings and conclusions by the FRC resulting from inspections of previous audits. The audit committee must also inform the board of the outcome of the statutory audit and explain how it contributed to the integrity of financial reporting and the audit committee’s role in the process.
Given the new legislative framework applying to the statutory audit of public interest entities, as introduced by the EU Statutory Audit Regulation and the EU Statutory Audit Amending Directive, ecoDa (the European Confederation of Directors’ Associations) and PwC published guidance in June 2016 to help audit committees understand the practical implications of the new legislation and provide examples of good practice.
In considering the governance of audit committees, the guidance looks at the new requirements in relation to the competence of the audit committee as a whole and that of its members, focusing on sector competence and independence issues. It considers the new mandatory audit firm rotation requirements and their impact on multinational groups, as well as issues concerning the auditor’s independence. In this context it looks at the need for approval of non-audit services by the audit committee and at the impact of this on multinational groups, at the requirements concerning the allowance of certain tax and valuation services, at the fee cap on permissible non-audit services and at the cooling off period for key audit personnel joining the audited entity. It also considers the new audit report requirements and those concerning the additional report to be given to the audit committee of a public interest entity (PIE). Finally, it looks at the new obligation on national competent authorities to monitor developments in the PIE audit market and at sanctions for breaches of the new requirements.
In May 2016, the Financial Reporting Council (FRC) published a feedback statement summarising responses to its October 2015 discussion paper, “UK Board Succession Planning”. The discussion paper was published because board evaluations often highlight the quality of succession planning as an issue, and the FRC has been asked to promote good practice in this area to raise quality.
Areas explored in the discussion paper and feedback statement include:
- How effective board succession planning is to business strategy and culture.
- The role of the nomination committee in succession planning.
- Board evaluation and its contribution to board succession.
- Identifying the internal and external “pipeline” for executive and non-executive directors.
- Ensuring diversity on the board.
- The role of institutional investors in succession planning.
The FRC is currently undertaking a “Culture Project” aimed at understanding how boards can shape, embed and assess culture, with the aim of identifying and promoting best practice. As part of that, and in light of the responses to the discussion paper on succession planning, the FRC is to consider providing guidance to nomination committees as part of the revision of its 2011 Guidance on Board Effectiveness. In addition, the FRC announced in the feedback statement that it will be reviewing and analysing nomination committee disclosures (including board evaluation reporting by the FTSE 350), and will comment on its findings in its 2016 “Developments in corporate governance and stewardship” report to be published in due course.
The focus on nomination committees has continued, with Institute of Chartered Secretaries and Administrators’ (ICSA) Governance Institute and EY also issuing a report in May 2016, “The Nomination Committee – Coming Out of the Shadows”. The report followed a series of discussions with mainly FTSE 350 board chairs, nomination committee chairs and members and company secretaries, and the purpose of the report is to help improve the effectiveness of nomination committees and succession planning.
The report looks at the role of the nomination committee, its membership and its reporting, and then focuses on three main themes:
- Looking deeper into the company to identify and help to develop its future leaders – this involves considering executive succession and the talent pipeline, as well as executive development.
- Casting the net wider to identify potential non-executive directors – this involves determining the specific skill sets required, as well as personal attributes.
- Thinking further ahead than the immediate replacement of a retiring board member – this will help the company prepare for future challenges.
The report concludes with a set of 12 questions for boards and their nomination committees to consider.
New board review
In February 2016, Sir Philip Hampton, currently chair of GlaxoSmithKline, was appointed chair and Dame Helen Alexander, currently chair of UBM, was appointed deputy chair of a new board review to continue the work of Lord Davies’ “Women on Boards Review”. The new board review will continue to champion work to improve the representation of women on FTSE 350 boards and consider options for building the talent pipeline, focussing on improving the representation of women in the executive layer of FTSE 350 companies. In July 2016 it was announced that the review would look to raise the target of women on FTSE 350 boards to 33 per cent by 2020 and it is expected that findings will be presented to the Government by the end of 2016.
Results of EHRC inquiry into FTSE 350 appointments
Since then, in March 2016, the Equality and Human Rights Commission (EHRC) published “An inquiry into fairness, transparency and diversity in FTSE 350 board appointments”. This report sets out the results of the inquiry launched by the EHRC back in 2014 into how FTSE 350 companies and research firms recruit and select board directors. The aim of the inquiry was to determine whether recruitment and selection practices are transparent, fair and result in selection on merit, and to identify areas where companies and search firms can make improvements to support more diverse appointments to company boards.
The report sets out a number of recommendations concerning board evaluations, diversity policies and targets, role descriptions, the search process, the selection of candidates, the role of the nomination committee and means of improving diversity in the talent pipeline and candidate pool. The EHRC has also produced a short six–step practical guide for companies to help them improve board diversity, both when making an appointment and in respect of on-going action that can be taken to increase diversity across the entire workforce, particularly to ensure a pipeline of diverse talent for future board appointments.
Report into gender imbalance in financial services firms
At the same time as the EHRC published the results of its inquiry, HM Treasury published a report it had commissioned by the CEO of Virgin Money, Jayne-Anne Gadhia, addressing the gender imbalance in senior positions in financial services companies. The Gadhia review had been asked to consider the representation of senior management roles in financial services firms as part of the Government’s commitment to tackle gender equality in the workplace.
The Gadhia review makes three over-arching recommendations to achieve a balanced workforce. These are as follows:
- Firms should set their own inclusive strategy and targets annually and progress against these internally generated targets should be reported.
- That inclusive strategy should then be owned and driven at executive committee level by a senior member of the committee who is accountable for improving gender diversity at all levels of the organisation and in all business units.
- Executive bonuses should be explicitly tied to achieving the internal targets which firms have set themselves since linking variable pay and performance to action against clear plans to promote diversity would send a strong message that firms take the issue seriously.
While the recommendations in the Gadhia report are voluntary, they do form part of a voluntary charter that HM Treasury has launched and which it hopes financial services organisations will sign to signify their commitment to take on board the recommendations. In July 2016 HM Treasury published a list of 72 financial services firms that have signed up to its Women in Finance Charter.
In April 2016, the Executive Remuneration Working Group set up by the Investment Association in autumn 2015, published an interim report on executive remuneration structures and practices. The Working Group was set up following concerns that the current structures of executive pay, and in particular their complexity, are inhibiting executive directors from acting in the best long-term interests of their companies and investors.
The interim report sets out specific concerns where the Working Group seeks further input. These are as follows:
- Transparency – the Working Group believes retrospective reporting of targets should be strongly encouraged so that it is clear how a bonus was calculated.
- Shareholder engagement – shareholders need to analyse the proposed structures and payments from both a governance and investment perspective.
- Accountability – remuneration committees need to be more accountable for the decisions they take and ensure that remuneration outcomes are realigned with overall business performance and strategy.
- Flexibility – companies should move away from a “one-size fits all” remuneration model and remuneration structures should be more tailored to the individual needs of the particular business and company strategy.
The Working Group is seeking views on some of the alternative structures which could be adopted and the parameters which would need to be established when moving from the current system to a more company-specific approach. In due course, following roundtable discussions with a wide range of stakeholder groups, the Working Group will publish its final report. The Investment Association will review that final report and decide whether or not to adopt its recommendations in its Principles of Remuneration which were last revised in November 2015.
In addition, in July 2016, the Investment Association published an updated version of its Principles of Remuneration, last published in November 2015. The only change made to the Principles concerns the timing of awards under long-term incentive schemes and the change has been made as a result of the implementation of the EU Market Abuse Regulation (Regulation EU596/2016). The Principles state that the rules of the scheme should provide that share or option awards should normally be granted within a 42 day period immediately following the end of the closed period under the Market Abuse Regulation (the previous requirement was that they be granted within 42 days following publication of the company’s results).
Also, in July 2016 the Quoted Companies Alliance (QCA) published its revised Remuneration Committee Guide for Small and Mid-Size Quoted Companies. The Guide (copies of which are available from the QCA), prepared to assist remuneration committee members of small and mid-size quoted companies in setting pay for executive directors and senior management in a fair and reasonable manner, was last published in 2012, and it has been revised and updated to address new remuneration regulations and developments in governance behaviour and best practice. Key changes include:
- A new section providing a high-level explanation of the changes to the legal regime for main market companies that took place in 2013.
- Specific reference made to clawback arrangements.
- Expanding the narrative on the roles and responsibilities of the people involved in the work of the remuneration committee, placing greater emphasis on the role of the remuneration committee chairman.
- Integrating aspects of the QCA’s Corporate Governance Code for Small and Mid-Size Quoted Companies (QCA Code), published in 2013 and of the Audit Committee Guide for Small and Mid-Size Quoted Companies, published in 2014.
- Expanding the section on communicating with shareholders and creating a new section on the remuneration report, to reflect the increased focus on relations with shareholders.
Review of the Pre-Emption Group’s Statement of Principles
In May 2016, the Pre-Emption Group published a monitoring report which looks at the implementation of the updated Statement of Principles in relation to pre-emption rights, published by the Pre-Emption Group in March 2015.
While research shows that generally the Statement of Principles was adhered to in 2015, in light of investor representatives’ views on best practice, the Pre-Emption Group has published two template resolutions with the monitoring report. These provide for the authority to disapply pre-emption rights in relation to the additional five per cent now permitted under the Statement of Principles, to be included in a separate resolution which specifically references use in connection with an acquisition or specified capital investment, as envisaged by the Statement of Principles. The template also sets out the disclosures investors expect to see when such an authority is sought. The monitoring report notes that in 2016 the Pre-Emption Group will be looking for continued improvement in disclosure of the intended and actual disapplication of pre-emption rights and for all companies to engage with their shareholders and adhere to the letter and spirit of the Statement of Principles.
Board oversight of profit expectations and dividend policy
The Investment Association wrote to the chairs of FTSE companies in May 2016, expressing its concerns over a number of instances where companies have made significant changes to their profit expectations and/or have reduced the company’s dividend policy following the appointment of new management. This has often resulted from the value of assets being written down and future profit expectations being scaled back significantly within a few months of the appointment of new management.
The letter points out that investors believe these actions highlight insufficient oversight on the part of independent directors and the audit committee. It reminds directors that they should be assessing the likely future profitability of the business and the valuation of its assets on an ongoing basis. If the prospects of the business are presented as being fundamentally different following the appointment of new management, resulting in a revaluation of assets and a cut in the dividend, then this raises questions about the board’s oversight of the previous management and why these issues were not addressed earlier. The letter points out that investors will hold independent directors to account when there is a significant revaluation of assets, profit forecasts and dividend policy following the appointment of new management and IVIS will highlight on an “Amber Top” the re-election of non-executive directors of any companies where the situation arises following the appointment of new management. This policy comes into effect for AGMs after August 1, 2016.
Updated Investment Association share capital management guidelines
In July 2016, the Investment Association published an updated version of its share capital management guidelines, last published in July 2014.
In terms of changes to the previous version, the guidelines note that Investment Association members support the Pre-Emption Group’s template resolutions for the disapplication of pre-emption rights (see further above) and will expect companies seeking an aggregate ten per cent disapplication authority to follow the model resolutions. They have asked the Institutional Voting Information Service (IVIS) to amber top any company seeking a ten per cent disapplication authority which does not use the two separate template resolutions from August 1, 2016, and to red top any company which does not use such resolutions from January 1, 2017.
Investment Association’s Productivity Action Plan
In March 2016, the Investment Association published an Action Plan, outlining how the investment industry can play a role in improving productivity in the UK with long-term investment.
The Action Plan sets out five investor productivity principles and 12 recommendations and associated actions relating to those principles. The principles are as follows:
- Enhance company reporting for efficient capital allocation – through investment and analytical expertise the investment industry will identify and finance those companies contributing productive growth in the economy.
- Enhance investor stewardship and engagement – the investment industry will engage with companies to help them achieve sustainable value creation over the long term and support investments in improved productivity.
- Simplify behavioural incentives and the investment chain – the investment industry will work to ensure that the agreed incentives and governance of the investment chain ensure a clear alignment with clients’ long term investment objectives.
- Develop efficient and diverse capital markets – as key capital market participants, the investment industry has a key role in the development of asset classes and the efficient functioning of capital markets.
- Overcome tax and regulatory impediments to the provision of long term finance – the investment industry should contribute to the debate on tax and regulatory impediments to investment so as to ensure the right long-term outcomes for clients.
The Action Plan’s success will be clearly measured every six months and the Investment Association will formally update the Chancellor of the Exchequer on its progress on the first and third anniversaries of the Plan’s publication outlining progress and development.
At a time when many companies are contemplating the preparation of their first slavery and human trafficking statement to meet the requirements of section 54 Modern Slavery Act 2015, the Equality and Human Rights Commission (EHRC) has published a short five-step guide for company boards to help directors understand what they need to do to “know” and “show” that their company respects human rights in practice. The five steps should help directors satisfy themselves that their company identifies, mitigates and reports on the human rights impact of the company’s activities and the guide also provides advice on how boards can meet the UN Guiding Principles on Business and Human Rights, the global standard, which outline the role of business and governments in respecting human rights.
The five steps are as follows:
- Directors should ensure the company embeds a responsibility to respect human rights into its culture, knowledge and practices.
- Directors should ensure the company identifies and understands its salient, or most severe, risks to human rights.
- Directors should ensure the company systematically addresses its salient, or most severe, risks to human rights and provides for remedies when needed.
- Directors should ensure the company engages with stakeholders to inform its approach to addressing human rights risks.
- Directors should ensure the company reports on its salient, or most severe, human rights risks and meets regulatory reporting requirements.
The Institute of Chartered Secretaries and Administrators’ (ICSA) Governance Institute published a consultation paper in May 2016 seeking views on the practice of minuting meetings. Responses to the consultation will help ICSA produce revised guidance on good practice that reflects the reality of modern market practice on a cross-sectoral basis. Questions in the consultation paper include questions about the legal and regulatory framework applying to minutes, responsibility for their production, questions about the drafting of the minutes, dealing with issues such as the level of detail and conflicts of interest, editing minutes, access to minutes and retention of the company secretary’s notes of meetings.